Monday, November 7, 2011

No Virgina, the CRA/GSE's Didn't Cause the Financial Crisis

One of the things that drives me nuts is when -- regardless of a point being thoroughly and completely dis-proven and debunked -- it still makes it's way into political discussion. Of course, most of the time these things pop up (the world isn't warming, evolution is only a theory) from some whack-job who can't handle the complexity of the modern world, and instead pines for a simpler idealized day (which of course, never really existed, but that doesn't stop them from thinking it existed). Or, they're just plain stupid. Either way, it's an attempt to obfuscate the basic data in furtherance of some meme.

Case in point: the CRA caused the melt-down. I love this theory. Never mind that the CRA was passed 25 years prior to the melt-down (that's one hell of a delayed reaction), nor the fact that real estate bubbles popped up all over the world (did Spain also have a CRA?) No -- these objective data points are not relevant! All government is bad, so the CRA is bad and that's that.

1.) Fed Chair Alan Greenspan dropped rates to 1 percent — levels not
seen for half a century — and kept them there for an unprecedentedly
long period. This caused a spiral in anything priced in dollars (i.e.,
oil, gold) or credit (i.e., housing) or liquidity driven (i.e., stocks).

2.) Low
rates meant asset managers could no longer get decent yields from
municipal bonds or Treasurys. Instead, they turned to high-yield
mortgage-backed securities. Nearly all of them failed to do adequate due
diligence before buying them, did not understand these instruments or
the risk involved. They violated one of the most important rules of
investing: Know what you own.

3.) Fund managers made this error
because they relied on the credit ratings agencies — Moody’s, S&P
and Fitch. They had placed an AAA rating on these junk securities,
claiming they were as safe as U.S. Treasurys.

4.) Derivatives had
become a uniquely unregulated financial instrument. They are exempt from
all oversight, counter-party disclosure, exchange listing requirements,
state insurance supervision and, most important, reserve requirements.
This allowed AIG to write $3 trillion in derivatives while reserving
precisely zero dollars against future claims.

6.) Wall
Street’s compensation system was skewed toward short-term performance.
It gives traders lots of upside and none of the downside. This creates
incentives to take excessive risks.

7.) The demand for higher-yielding paper led Wall Street to begin
bundling mortgages. The highest yielding were subprime mortgages. This
market was dominated by non-bank originators exempt from most
regulations. The Fed could have supervised them, but Greenspan did not.

8.)
These mortgage originators’ lend-to-sell-to-securitizers model had them
holding mortgages for a very short period. This allowed them to get
creative with underwriting standards, abdicating traditional lending
metrics such as income, credit rating, debt-service history and
loan-to-value.

10.) To keep up with these newfangled
originators, traditional banks developed automated underwriting systems.
The software was gamed by employees paid on loan volume, not quality.

11.) Glass-Steagall
legislation, which kept Wall Street and Main Street banks walled off
from each other, was repealed in 1998. This allowed FDIC-insured banks,
whose deposits were guaranteed by the government, to engage in highly
risky business. It also allowed the banks to bulk up, becoming bigger,
more complex and unwieldy.

12.) Many states had anti-predatory lending
laws on their books (along with lower defaults and foreclosure rates).
In 2004, the Office of the Comptroller of the Currency federally
preempted state laws regulating mortgage credit and national banks.
Following this change, national lenders sold increasingly risky loan
products in those states. Shortly after, their default and foreclosure
rates skyrocketed.

1. Private markets caused the shady mortgage boom:
The first thing to point out is that the both the subprime mortgage
boom and the subsequent crash are very much concentrated in the private
market, especially the private label securitization channel (PLS)
market. The Government-Sponsored Entities (GSEs, or Fannie and Freddie)
were not behind them. The fly-by-night lending boom, slicing and dicing
mortgage bonds, derivatives and CDOs, and all the other shadiness of
the mortgage market in the 2000s were Wall Street creations, and they
drove all those risky mortgages.

Here’s some data
to back that up: “More than 84 percent of the subprime mortgages in
2006 were issued by private lending institutions… Private firms made
nearly 83 percent of the subprime loans to low- and moderate-income
borrowers that year.”

As Center For American Progress’s David Min pointed out to
me, the timing doesn’t work at all: “But from 2002-2005, [GSEs] saw a
fairly precipitous drop in market share, going from about 50% to just
under 30% of all mortgage originations. Conversely, private label
securitization [PLS] shot up from about 10% to about 40% over the same
period. This is, to state the obvious, a very radical shift in mortgage
originations that overlapped neatly with the origination of the most
toxic home loans.”

2. The government’s affordability mission didn’t cause the crisis:
The next thing to mention is that the “affordability goals” of the
GSEs, as well as the Community Reinvestment Act (CRA), didn’t cause the
problems. Randy Krozner summarized
one of the better studies on this so far, finding that “the very small
share of all higher-priced loan originations that can reasonably be
attributed to the CRA makes it hard to imagine how this law could have
contributed in any meaningful way to the current subprime crisis.” The
CRA wasn’t nearly big enough to cause these problems.

3. There is a lot of research to back this up and little against it:
This is not exactly an obscure corner of the wonk world — it is one of
the most studied capital markets in the world. What has other research
found on this matter? From Min:

Did Fannie and Freddie buy high-risk mortgage-backed securities?
Yes. But they did not buy enough of them to be blamed for the mortgage
crisis. Highly respected analysts who have looked at these data in much
greater detail than Wallison, Pinto, or myself, including the
nonpartisan Government Accountability Office, the Harvard Joint Center
for Housing Studies, the Financial Crisis Inquiry Commission majority,
the Federal Housing Finance Agency, and virtually all academics,
including the University of North Carolina, Glaeser et al at Harvard,
and the St. Louis Federal Reserve, have all rejected the Wallison/Pinto
argument that federal affordable housing policies were responsible for
the proliferation of actual high-risk mortgages over the past decade.

The other side has virtually no research conducted that explains their argument, with one exception that I’ll cover below.

4.Conservatives sang a different tune before the crash:
Conservative think tanks spent the 2000s saying the exact opposite of
what they are saying now and the opposite of what Bloomberg said above.
They argued that the CRA and the GSEs were getting in the way of
getting risky subprime mortgages to risky subprime borrowers.

My personal favorite is Cato’s “Should CRA Stand for ‘Community Redundancy Act?’” from 2000 (here’s a write-up by James Kwak), which argues a position amplified in its 2003 Handbook for Congress financial deregulation chapter:
“by increasing the costs to banks of doing business in distressed
communities, the CRA makes banks likely to deny credit to marginal
borrowers that would qualify for credit if costs were not so high.”
Replace “marginal” with Bloomberg’s “on the cusp” and you get the same
idea.

Bill Black went through
what AEI said about the GSEs during the 2000s and it is the same thing —
that they were blocking subprime loans from being made. In the words
of Peter Wallison in 2004: “In recent years, study after study has
shown that Fannie Mae and Freddie Mac are failing to do even as much as
banks and S&Ls in providing financing for affordable housing,
including minority and low income housing.”

5. Expanding the subprime loan category to say GSEs had more exposure makes no sense:
Some argue that the GSEs had huge subprime exposure if you create a
new category that supposedly represents the risks of subprime more
accurately. This new “high-risk” category is associated with a
consultant to AEI named Ed Pinto, and his analysis deliberately blurs
the wording on “high-risk” and subprime in much of his writings. David
Min broke down the numbers, and I wrote about it here. Here’s a graphic from Min’s follow-up work, addressing criticism:

Even this “high risk” category isn’t risky compared to subprime and
it looks like the national average. When you divide it by private label,
the numbers are even worse.
Private label loans “have defaulted at over 6x the rate of GSE loans,
as well as the fact that private label securitization is responsible
for 42% of all delinquencies despite accounting for only 13% of all
outstanding loans (as compared to the GSEs being responsible for 22% of
all delinquencies despite accounting for 57% of all outstanding
loans).” The issue isn’t this fake “high risk” category, it is subprime
and private label origination.